Discounted cash flow represents financial flows associated with various projects and adjusted according to how they are distributed over time and potential interest on invested funds. Here it is very important to take into account the time aspect, since most investment projects are characterized by the fact that the main costs or outflows of funds occur in the first years, and income from them, that is, cash inflows, will be distributed for many years to come.
Economic value
The cost of the company’s functioning depends on the main factors, which are the value of the assets on the market, as well as the amount of income that is received as a result of the effective implementation of activities at the current time. The goal of potential investors is to obtain a very specific profit from their capital. Therefore, the profitability of the functioning of the organization is a very important point not only for owners, but also for investors, which is why it is taken into account during the implementation of valuation work in order to determine the value of a business.
The method of discounted cash flows has become one of the most frequently used in assessing these characteristics. This approach is relevant due to the fact that the cash flow management process for all parties is of incredible importance: it can be used to manage the value of the business, increasing the financial flexibility of the company itself. Discounted cash flow is able to compare income and expenses taking into account depreciation and amortization, receivables, capital investments, changes in the structure of working capital of the company itself. That is why many use this method for calculations.
How to use?
Empirical data showed that discounted cash flow is in a certain correlation with the value of the enterprise in the market, but the profit in the accounting sense does not correlate well with the market value, because the former can not always serve as a determining factor in the value of the enterprise.
When using this method, cost is calculated in a certain way. The analysis and forecasting of gross income, investments and expenses, the calculation of financial flows for each reporting year, the discount rates are calculated, and then the available cash flows are discounted, the residual value is calculated. After all this, you need to summarize the current values of future cash flows with the residual value, adjust and verify the results.
Different calculation options
The method of discounted cash flows allows you to use two types to calculate the value of the enterprise: equity and investment capital. If we are talking about equity, then the most important indicator is the degree of value of the data obtained for the company manager, since the need of the company to raise funds is taken into account. In practice, non-debt cash flow is used by investors to finance mergers, acquisitions or acquisitions of a company by attracting new funds from borrowers.
The calculation of the discounted cash flow for the capital of the company is made in a special way. Depreciation and changes in long-term debt are added to the net profit for a certain period, and the investment for the period and the increase in working capital of the company are subtracted from the amount received.It is important to understand that cash flows are projected for the next 5 years. The probability that there will be certain deviations from the forecast is high, so a whole range of forecasts is compiled: optimistic, pessimistic and most probable. For each, a weighted average yield is calculated and a specific weight is put down. Cash flow for equity and borrowed capital can be nominal or real. The discounted cash flow value is determined at the end or middle of the year. In the latter case, the result will be more accurate, therefore it is preferable.
Discount rate
In the process of determining the discount rate, it is necessary to understand that it is considered as the lower marginal level of profitability of investments, sufficient for the investor to see the feasibility of investing their funds in the company, especially when considering the possibility of alternative investments involving income from a certain degree of risk. Here, risk is understood as the probability of the discrepancy of expectations with actually obtained results, as well as loss of property due to bankruptcy of an enterprise, economic or political factors, as well as events of a different nature.
What to do next?
When discounted Net cash flow calculated, you should identify the amount of business income that will take place in the post-forecast period. The calculation is based on the fact that the residual value is the current value of the cash flow received after a discrete forecast period. It includes the value of all financial flows in all periods that remained outside the framework of one forecast year. The residual value can be calculated using one of the methods.
The net asset valuation method requires the residual carrying amount at the end of the period to be used as residual value. For a profitable enterprise, the use of this method is inappropriate.
For the assessment of liquid value, it is required to calculate its indicator for assets at the end of the forecasting period. There is a combination of factors influencing liquidity value. Here we can distinguish low attractiveness due to inappropriate appearance, industry factors and territorial distribution.
findings
For completeness of the assessment made for the existing company, you can use both discounted cash flow and market or costly. With this, you can avoid some degree of subjectivity by making the assessment of the business as accurate as possible.
